11 Analysis of Financial Statements and Cash Flow

PowerPoint Presentation: 

ANALYSIS OF FINANCIAL STATEMENTS AND CASH FLOW Norman R. Ramos LGU Finance Advisor, ADB TA 7451-PHI Support to Local Government Financing November 2011

FINANCIAL STATEMENT ANALYSIS : 

FINANCIAL STATEMENT ANALYSIS 2

FINANCIAL STATEMENT ANALYSIS: 

FINANCIAL STATEMENT ANALYSIS Financial Statement Analysis is an attempt to work with the reported financial figures to assess the entity's financial strengths and weaknesses. It involves the calculation of various ratios. It is used by such interested parties as creditors, investors, and managers to determine the firm's financial position relative to that of others The way in which an entity's financial position and operating results are viewed by investors and creditors will have an impact on the firm's reputation, price/earnings ratio, and effective interest rate.

FINANCIAL STATEMENTS: 

FINANCIAL STATEMENTS The financial statements present the summarized data of assets , liabilities, and equities in the Balance Sheet and its revenue and expenses in the Income Statement. If not analyzed, such data may lead one to draw erroneous conclusions about the entity’s financial condition . A financial analyst uses the ratios to make 2 types of comparisons : a) Industry Comparison b) Trend Analysis

COMPARISONS : 

COMPARISONS Industry Comparison – the ratios of a firm entity are compared with those of similar firms or with industry averages or norms to determine how the company is faring relative to its competitors. 2 . Trend Analysis - A firm's present ratio is compared with its past and expected future ratios to determine whether the company's financial condition is improving or deteriorating over time.

TYPES OF FINANCIAL RATIOS: 

TYPES OF FINANCIAL RATIOS 1. Liquidity Ratios 2 . Activity Ratios 3 . Leverage Ratios 4 . Profitability Ratios

LIQUIDITY RATIOS : 

LIQUIDITY RATIOS Analyzing liquidity is especially important to creditors . If a company has a poor liquidity position, it may be a poor credit risk, perhaps unable to make timely interest and principal payments. Liquidity ratios are static in nature as of year-end . Thus, it is also important for management to look at expected future cash flows. If future cash outflows are expected to be high relative to inflows, the liquidity position of the company will deteriorate.

NET WORKING CAPITAL: 

NET WORKING CAPITAL Net W orking Capital = Current Assets - Current Liabilities Current Assets - assets that are expected to be converted into cash or used up within 1 year . Current Liabilities - liabilities that must be paid within 1 year; they are paid out of current assets. Net working capital is a safety cushion to creditors . A large balance is required when the firm has difficulty borrowing on short notice .

CURRENT RATIO: 

CURRENT RATIO Current Ratio =­­­­­­­­­­­­­­­­­ Current Assets Current Liabilities Current Ratio is subject to seasonal fluctuations. Used to measure the ability of an enterprise to meet its current liabilities out of current assets. A high ratio is needed when the firm has difficulty borrowing on short notice. Limitations: a) Ratio may rise just prior to financial distress because of a firm's desire to improve its cash position by selling fixed assets. This would have a detrimental effect upon productive capacity . b) Another limitation of the current ratio is that it will be excessively high when inventory is carried on the last-in, first-out (LIFO) basis.

QUICK (ACID TEST) RATIO : 

QUICK (ACID TEST) RATIO Quick Ratio = Cash + Marketable Securities + Accounts Receivable Current Liabilities Quick (Acid-test) Ratio - a stringent test of liquidity. Computed by dividing the most liquid current assets (cash, marketable securities, and accounts receivable) by current liabilities . Inventory is not included because of the length of time needed to convert inventory into cash . Prepaid expenses are also not included because they are not convertible into cash and so are not capable of covering liabilities .

ACTIVITY/ASSET UTILIZATION RATIOS: 

ACTIVITY/ASSET UTILIZATION RATIOS Activity ratios are used to determine how quickly various accounts are converted into sales or cash. Overall liquidity ratios generally do not give an adequate picture of a company's real liquidity, due to differences in the kinds of current assets and liabilities the company holds . Thus , it is necessary to evaluate the activity or liquidity of specific current accounts . Various ratios exist to measure the activity of receivables, inventory, and total assets.

ACCOUNTS RECEIVABLE RATIOS: 

ACCOUNTS RECEIVABLE RATIOS Accounts receivable ratios consist of: Accounts Receivable Turnover Ratio Average Collection Period

ACCOUNTS RECEIVABLE TURNOVER RATIO: 

ACCOUNTS RECEIVABLE TURNOVER RATIO The Accounts Receivable Turnover - gives the number of times accounts receivable is collected during the year . Accounts Receivable = Net Credit Sales or if not available, Total Sales Turnover Ratio Ave. Accounts Receivable Ave. Accounts Receivable = Beginning A/R + Ending A/R 2 In general, the higher the accounts receivable turnover, the better since the company is collecting quickly from customers and these funds can then be invested. An excessively high ratio may indicate that the company's credit policy is too stringent, with the company not tapping the potential for profit through sales to customers in higher risk classes .

AVE. COLLECTION PERIOD: 

AVE. COLLECTION PERIOD Ave. Collection Period = 365 . Accounts Receivable Turnover The answer is expressed in days for a sale to be converted into cash . If there is substantial increase in collection days, there exists a danger that customer balances may become uncollectible . A possible cause for the increase may be that the company is now selling to highly marginal customers . The analyst should compare the company's credit terms with the extent to which customer balances are delinquent An Aging Schedule , which lists the accounts receivable according to the length of time they are outstanding, would be helpful for this comparison .

INVENTORY RATIOS: 

INVENTORY RATIOS If a company is holding excess inventory, it means that funds which could be invested elsewhere are being tied up in inventory . In addition, there will be high carrying cost for storing the goods, as well as the risk of obsolescence . On the other hand, if inventory is too low, the company may lose customers because it has run out of merchandise . 2 major ratios for evaluating inventory: a) Inventory Turnover b) Ave. Age of Inventory

INVENTORY TURNOVER RATIO: 

INVENTORY TURNOVER RATIO Inventory Turnover = Cost of Goods Sold Ratio Average inventory Ave. Inventory = Beginning Inventory + Ending Inventory 2 The decline in the inventory turnover indicates the stocking of goods . Determine whether specific inventory categories are not selling well and the reasons for this. Perhaps there are obsolete goods on hand not actually worth their stated value. However , a decline in the turnover rate would not cause concern if it were primarily due to the introduction of a new product line for which the advertising effects have not been felt yet.

TOTAL ASSET TURNOVER RATIO: 

TOTAL ASSET TURNOVER RATIO Total Asset Turnover = Net Sales Ave. Total Assets Ave. Total Assets = Beginning Tot Assets + Ending Tot Assets 2 The total asset turnover ratio is helpful in evaluating a company's ability to use its asset base efficiently to generate revenue. A low ratio may be due to many factors and it is important to identify the underlying reasons . For example, is investment in assets excessive when compared to the value of the output being produced ? If so, the company might want to consolidate its present operation, maybe by selling some of its assets and investing the proceeds for a higher return or using them to expand into a more profitable area .

INTERRELATIONSHIP OF LIQUIDITY AND ACTIVITY TO EARNINGS: 

INTERRELATIONSHIP OF LIQUIDITY AND ACTIVITY TO EARNINGS Maintaining a proper balance between liquidity and return is important to the overall financial health of a business. Liquidity risk is minimized by holding greater current assets than noncurrent assets. However, the rate of return will decline because the return on current assets (i.e., marketable securities) is typically less than the rate earned on productive fixed assets. Also, excessively high liquidity may mean that management has not aggressively searched for desirable capital investment opportunities. High profitability does not necessarily infer a strong cash flow position. Income may be high but cash problems may exist because of maturing debt and the need to replace assets, among other reasons.

LEVERAGE RATIOS: 

LEVERAGE RATIOS Solvenc y - a company's ability to meet its long-term obligations as they become due . An analysis of solvency concentrates on the long-term financial and operating structure of the business. The degree of long-term debt in the capital structure is also considered. Further , solvency is dependent upon profitability since in the long run a firm will not be able to meet its debts unless it is profitable. When debt is excessive, additional financing should be obtained primarily from equity sources. Management might also consider lengthening the maturity of the debt and staggering the debt repayment dates.

DEBT RATIO: 

DEBT RATIO Debt Ratio = Total Liabilities Total Assets Debt Ratio - compares total liabilities (total debt) to total assets. It shows the percentage of total funds obtained from creditors. Creditors would rather see a low debt ratio because there is a greater cushion for creditor losses if the firm goes bankrupt.

DEBT/EQUITY RATIO: 

DEBT/EQUITY RATIO Debt/Equity Ratio = Total Liabilities Stockholder ’ Equity Debt/Equity Ratio - a significant measure of solvency since a high degree of debt in the capital structure may make it difficult for the company to meet interest charges and principal payments at maturity. Further , with a high debt position comes the risk of running out of cash under conditions of adversity. Also , excessive debt will result in less financial flexibility since the company will have greater difficulty obtaining funds during a tight money market .

PROFITABILITY RATIOS : 

PROFITABILITY RATIOS An indication of good financial health and how effectively the firm is being managed is the company's ability to earn a satisfactory profit and return on investment . Creditors will shy away from companies with deficient profitability since the amounts owed to them may not' be paid. Absolute peso profit by itself has little significance unless it is related to its source.

GROSS PROFIT MARGIN : 

GROSS PROFIT MARGIN Gross Profit Margin = Gross Profit Net Sales Gross Profit Margin - reveals the percentage of each peso left over after the business has paid for its goods. The higher the gross profit earned, the better.

PROFIT MARGIN : 

PROFIT MARGIN Profit Margin = Net Income Net S ales Profit Margin - indicates the profitability generated from revenue and hence is an important measure of operating performance . It also provides clues to a company's pricing, cost structure, and production efficiency .

RETURN ON TOTAL ASSETS (ROA): 

RETURN ON TOTAL ASSETS (ROA) Return on T otal Assets = N et I ncome Ave Total Assets Return on T otal Assets - indicates the efficiency with which management has used its available resources to generate income .

RATIO ANALYSIS: SUMMARY: 

RATIO ANALYSIS: SUMMARY Relevant ratios depend on whose perspective. A banker is concerned with the firm's liquidity position in deciding whether to extend a short-term loan A long-term creditor has more interest in the entity's earning power and operating efficiency as a basis to pay off the debt at maturity. Stockholders are interested in the long-run profitability of the firm since that will be the basis for dividends and appreciation in the market price of stock. Management is interested in all aspects of financial analysis since they are concerned with how the firm looks to both the investment and credit communities.

RATIO ANALYSIS: SUMMARY: 

RATIO ANALYSIS: SUMMARY Once a ratio is computed, it is compared with related ratios of the company, the same ratios from previous years, and the ratios of competitors. The comparisons show trends over a period of time and hence the ability of an enterprise to compete with others in the industry. Ratio comparisons do not mark the end of the analysis of the company, but rather indicate areas needing further attention .

CASH FLOW ANALYSIS : 

CASH FLOW ANALYSIS 28

CASH FLOW ANALYSIS: 

CASH FLOW ANALYSIS Cash flow analysis - evaluation of the statement of cash flows in order to determine the impact that its sources and uses of cash have on the operations and financial condition. It is used in decisions that involve investments, operations, and financing.

STATEMENT OF CASH FLOW: 

STATEMENT OF CASH FLOW Statement of Cash Flows - shows the sources and uses of cash, which is a basis for cash flow analysis for financial managers . Specific questions that can be answered by the statement of cash flows and cash flow analysis: 1 . Is the company growing or just maintaining its competitive position? 2. Will the company be able to meet its financial obligations? 3. Where did the company obtain funds? 4. What use was made of net income?

STATEMENT OF CASH FLOW: 

STATEMENT OF CASH FLOW 5 . How much of the required capital has been generated internally? 6. How was the expansion in plant and equipment financed? 7. Is the business expanding faster than it can generate funds? 8. Is the company's dividend policy in balance with its operating policy ? 9. Is the company's cash position sound and what effect will it have on the market price of stock?

STATEMENT OF CASH FLOW: 

STATEMENT OF CASH FLOW Cash is vital to the operation of every business . How management utilizes the flow of cash can determine a firm's success or failure. Financial managers must control their company's cash flow so that bills can be paid on time and extra pesos can be put into the purchase of inventory and new equipment or invested to generate additional earnings . Transactions involving cash may be classified into 3 types: a. Operating b. Investing c. Financing

OPERATING ACTIVITIES: 

OPERATING ACTIVITIES Operating Activities - transactions that are not investing or financial activities. They only relate to income statement items. Cash Inflows - cash received from the sale of goods or services, including the collection or sale of trade accounts and notes receivable from customers, interest received on loans, and dividend income. Cash Outflows - cash paid to acquire materials for the manufacture of goods for resale, rental payments to landlords, payments to employees as compensation, and interest paid to creditors.

INVESTING ACTIVITIES: 

INVESTING ACTIVITIES Cash Inflows – cash from the sale of property, plant, and equipment used in the production of goods and services, debt instruments or equity or other entities, and the collection of principal on loans made to other enterprises. Cash Outflows – may result from the purchase of plant and equipment and other productive assets, debt instruments or equity of other entities, and the making of loans to other enterprises

FINANCING ACTIVITIES: 

FINANCING ACTIVITIES Cash Inflows – cash from sale of a company's own preferred and common stock, bonds, mortgages, notes, and other short- or long-term borrowings. Cash Outflows - repayment or short- and long- term debt, the reacquisition of treasury stock, and the payment of cash dividends.